Shadow inventory threatens office vacancies

For months, real estate experts have been whispering fearfully of “the shadow inventory” in residential sales. Now, we’re starting to hear rumblings of shadow inventory threatening the commercial market, particularly with respect to office vacancies. Shadow inventory is the inventory of homes that are probably going to be for sale really soon, but are not on the market just yet.

For example, many bank-owned foreclosures sit vacant for months before becoming officially listed for sale by a real estate brokerage.

Some real estate experts believe banks are purposefully holding off on listing properties because they don’t want to flood the market with their foreclosures. They’d rather hold them a bit and feed them out to the market in a slower, more controlled fashion, rather than dumping them quickly and depressing prices even further. Banks believe prices will be kept more stable by this technique. Experts fear if banks do suddenly open the gates and put all their foreclosures on the market as quickly as they acquire them, this shadow inventory will devastate prices.

Vacant offices, empty cubicles

So far, we haven’t seen this happen in residential sales. Now we are starting to hear the same kind of terminology, and logic, applied to commercial properties, not in talks of foreclosures, but in regards to office space.

Shadow inventory, in this sense, is commercial property that is currently vacant (completely empty or sections of an office), yet not on the market. Picture a large office building with chunks of vacant space. Or one company’s office with entire sections of empty cubicles or conference rooms gathering dust.

These spaces are underutilized or vacant, yet not officially listed with a broker. Since it’s not being marketed, experts cannot count or quantify just how big this shadow inventory is, or how big a potential problem it could be in the future. No matter how much is there, everyone can agree that if it was added to the known office vacancy numbers, the commercial leasing sector would certainly look even bleaker than it is now.

Why aren’t they listed?

If you have excess office space, why wouldn’t you list it for rent? Well, for one, if it’s only part of a floor or a section of your office, it can be hard to subdivide and sublease unless you find the perfect tenant that meshes with your own use.

If you have 10-25% vacant space in your current office, could you take in another company to share the rent or not? Maybe at 25% of more you’d have to do it, to survive and pay the rent. But at a lower rate, would it be worth the hassle? Maybe not. Many companies would cut costs and struggle to pay the rent alone rather than take in another company under their own roof.

If you do go this route, you have to think about fitting out the space to match the needs of the new tenant. How many months are left on your lease and do your needs and future needs fit with their needs? What about logistics and even the legal ability to sublease, with your lease terms?

Hanging in until leases renew

As leases come up for renewal, many tenants are looking hard at their leases and how much space they are truly using. If you’ve had downsizing and layoffs, does it make sense to also downsize the office space? Many business owners are hanging in there, waiting for their lease to expire. Then what?

I represented one client who tried to negotiate their lease renewal by downsizing their space (and rent) with the landlord. Negotiations failed. That client came to me and I found them a larger space for a significantly lower price. We even negotiated landlord financed fit out into the deal.Yes, they got more space at less money. They moved.

I have another tenant who has feelers out there looking for a cheaper retail space. She’s been in her space for years, and has several more years on her lease left. The landlord won’t allow her to renegotiate the rent, despite the fact she is clearly struggling every month to pay on time. He won’t allow her to cut the space, either. She may go under and then both parties lose.

On the flip side, another landlord allowed his professional tenant to break the lease early (years early in fact) with a small payout to the landlord, rather than holding him to the terms. Both walked away from the deal and now the property is ready to be rented again. This landlord has an excellent reputation of working with tenants, and I anticipate re-renting that space shortly.

Be flexible, or fear the shadow!

Landlords who are open to negotiations, willing to work with tenants and help them through the tough times will prosper and won’t be faced with increasing vacancies.

Landlords unable or unwilling to make accommodations during this rough economy will suffer higher vacancies. And as those leases expire and more and more office spaces become vacant, eventually they will find their ways to the market. When that happens, office rental rates will fall even further.

Wouldn’t it be better to suck it up and help tenants through the rough patch than see them pack up and move? During these trying times, everyone is taking it on the chin. The shadow inventory may or may not come to haunt us later. Who knows. But from what I see in my market, tenants are quietly downsizing and making plans to move when leases expire.

Erica Ramus is the Broker/Owner of Ramus Realty Group in Pottsville, PA. She also teaches real estate licensing courses at Penn State Schuylkill and is extremely active in her community, especially the Rotary Club of Pottsville and the Schuylkill Chamber of Commerce. Her background is writing, marketing and publishing, and she is the founder of Schuylkill Living Magazine, the area's regional publication. She lives near Pottsville with her husband and two teenage sons, and an occasional exchange student passing thru who needs a place to stay.

13 Comments

Hi Erica, This is a terrifically clear description of what Shadow Space is for the uninitiated. Bravo! I am noticing more frequently in my Greater Boston office space marketplace where many larger tenants (typically with 20,000sf or more), with significant term remaining on their leases, are holding on to their presently underutilized space in anticipation of the recovery. Compared to many areas of the country, we’ve been somewhat insulated from the worst effects of the recession because of our fairly diverse local economy, with heavy concentrations of higher education, biomedical / pharma and technology, but financial services has taken a hit just like in most markets.
I enjoy your posts!

Commercial real estate outlook is positive

According to the National Association of Realtors’ (NAR) quarterly forecast, commercial real estate is continuing to improve, but the pace is slowing.

Dr. Lawrence Yun, NAR chief economist, said that fundamentals are still on an uptrend. “Growth in commercial real estate sectors continues at a moderate pace from a very slow pace of absorption, despite job additions to the economy. Companies appear hesitant to add new space,” he said.

“Office demand is expected to see only slow and gradual improvement,” Dr. Yun added. “Demand for retail space is benefiting from improved household wealth, while industrial real estate is stable with increasing international trade, which requires warehouse space. Of course, the apartment market fundamentals are the strongest, as nearly all of the new household formation in the past 10 years has come from renters, and not homeowners.”

Forecasting the future

Overall, national vacancy rates in the coming year are forecast to drop 0.2 percentage point in the office sector (the sector with the worst vacancy rates) to 15.6 percent in the first quarter of 2015.

Vacancy rates are projected to fall 0.1 point in industrial to 8.9 percent, and 0.3 point for retail real estate to 9.9 percent.

With rising apartment construction, the average multifamily vacancy rate will edge up 0.1 percent to 4.1 percent, but this sector continues to experience the tightest availability and strongest rent growth of all the commercial sectors.

Rental rates for various sectors

Office rents are projected to increase 2.3 percent in 2014 and 3.2 percent next year. Net absorption of office space in the U.S., which includes the leasing of new space coming on the market as well as space in existing properties, is likely to total 44.6 million square feet this year and 50.0 million in 2015.

Annual industrial rents should rise 2.4 percent this year and 2.6 percent in 2015. Net absorption of industrial space nationally is seen at 106.1 million square feet in 2014 and 110.6 million next year.

Average retail rents are forecast to rise 2.0 percent in 2014 and 2.3 percent next year. Net absorption of retail space is likely to total 14.6 million square feet this year and 20.9 million in 2015.

Average apartment rents are projected to rise 4.3 percent this year and 3.5 percent in 2015. Multifamily net absorption is expected to total 204,900 units in 2014 and 112,500 next year.

Regional performance varies

The markets with the lowest office vacancy rates in the first quarter are New York City, with a vacancy rate of 9.5 percent; Washington, D.C., at 10.2 percent; Little Rock, Ark., 11.6 percent; Birmingham, Ala., 12.7 percent; and San Francisco and Nashville, Tenn., at 12.8 percent each.

The areas with the lowest industrial vacancy rates currently are Orange County, Calif., with a vacancy rate of 3.7 percent; Los Angeles, 3.8 percent; Miami, 5.8 percent; Seattle at 5.9 percent; and San Riverside/Bernardino, Calif., at 6.1 percent.

Markets with the lowest retail vacancy rates include San Francisco, at 3.1 percent; Fairfield County, Conn., 3.8 percent; Long Island, N.Y., 4.8 percent; San Jose, Calif., 5.2 percent; and Northern New Jersey and Orange County, Calif., at 5.3 percent each.

Areas with the lowest multifamily vacancy rates currently are New Haven, Conn., at 2.1 percent; Minneapolis and New York City, 2.3 percent; and Oakland-East Bay, Calif., and San Diego, at 2.5 percent each.

Should you buy or lease office space? 5 questions to consider

Should you buy or lease an office space?

Many people set up shop and lease office space, assuming this is their best, and often only option, but there are some instances where buying office space is a better option. Many blindly make this decision based on a gut feeling, and we’re not saying that is a bad thing, we’re saying that in addition to that instinct, these five questions should be asked when considering whether you should lease or buy an office space.

1. Is your business well-established?

If your business is still in the startup phase, I rarely recommend buying. During the next 5 to 10 years you’ll experience employee count fluctuations, client and customer oscillations and even business direction and strategy adjustments. That is, you’ll need to be flexible, not tied to a certain space. Additionally, any leftover capital should most likely be recycled back into your budding startup. You don’t want to stretch yourself too thin.

The only exception that applies some of the time — not every time — is if your startup is in the technology space. Oftentimes tech employees can work remotely, or the technology is automated and won’t require more employees in the future. Additionally, clients of many tech startups can successfully access the company’s offering without visiting a physical office space.

2. Will you endanger your business with a property purchase?

Yes, buying can be a great investment and add a source of revenue, but even well-established business owners need to think about the stress that buying a property can put on their bottom line. Oftentimes your time and money is best spent on what you do best, running your enterprise. If buying means you won’t be able to focus essential resources to your first priority, your business, then you might want to hold off on buying.

Further, because commercial real estate can be a great investment, business owners are sometimes so eager to get in the game that they sell off portions of their business to finance the purchase. This is a bad idea. You should not let real estate decisions determine how you run your business. You’ve worked long and hard to build a successful company — don’t give it away. Another deal with always come along.

3. Do you have heavy, difficult-to-move equipment?

If you have machinery or specialized equipment that make it difficult for you to move, buying may be a great option for you. Two primary reasons: 1.) Lugging dense equipment from leased space to leased space is annoying, cumbersome and costly.

Plus, you increase the chances of damaging it every time you move. 2.) When a landlord knows it’s difficult for you to relocate, he or she is holding the cards when it’s time to renew your lease. If your lease doesn’t have a stipulation to remediate this, leasing office space will cost you more money than it should. More often than not, buying a custom space for your specialized equipment is the way to go.

4. Does your location affect employees or clients?

If attracting and maintaining top-notch employees means securing office space in your city’s prime business district, finding the perfect space to buy may be difficult. Why? Prime business districts usually have lower vacancy rates, which typically means higher prices plus fewer properties to choose from. Anytime you’re limited to a narrow location, you risk not landing the best deal. This doesn’t mean don’t buy, just understand what you’re up against from the onset.

The other issue you may face in buying location-specific space is when your customers or clients depend on your position for convenience. This is a challenge when and if your city’s submarkets are in transition. The trendy spot of the last five years, may not be in vogue five years from now. A lease allows flexibility to move where your customer and clients need you to be.

5. Are you prepared to be a landlord?

There’s a lot of maintenance that goes along with owning a building. Will you have the ability to hire a maintenance crew or will you tend the bathrooms, burnt out light bulbs and overflowing trash bins yourself?

Furthermore, many landlords have easy access to financing that could benefit you in the form of a tenant improvement package. Even though you may have capital to buy your building, can you afford to build it out the way you want to? The cost of ownership is sometimes underestimated. Make sure you’ve considered all of the possible expenses that go along with buying your office space.

Commercial real estate improving modestly, little change to come

Commercial real estate sector is improving

According to the National Association of Realtors’ (NAR) quarterly commercial real estate forecast, commercial real estate is improving modestly, with little change seen for the near future. Dr. Lawrence Yun, NAR’s Chief Economist said in a statement, “Jobs are the key driver for commercial real estate, and the accumulation of 7 million net new jobs from the low point a few years ago is steadily showing up as demand for leasing and purchases of properties,” he said. “But the difficulty of accessing loans remains a hindrance to a faster recovery.”

NAR reports that leasing activity rose 2.0 percent in the third quarter compared to the second, and sales levels are higher than a year ago.

Yun said there have been some shifts in commercial purchases. “Investors have been looking for better yields, and have found good potential in smaller commercial properties, notably in secondary and tertiary markets. Sales of commercial properties costing less than $2.5 million in the third quarter were 11 percent above a year ago, while prices for smaller properties were 4 percent above the third quarter of 2012.”

Commercial investment in properties costing more than $2.5 million rose 26 percent from a year ago, while prices for large properties were 9 percent above the third quarter of 2012.

National vacancy rates over the coming year are forecast to decline 0.2 percentage point in the office market, 0.6 point in industrial, and 0.5 point for retail real estate. The average multifamily vacancy rate will edge up 0.1 percent, but that sector continues to see the tightest availability and biggest rent increases.

Retail vacancy rates should be going down

Retail vacancy rates are forecast to decline from 10.4 percent in the fourth quarter of this year to 9.9 percent in the fourth quarter of 2014. Average retail rents should increase 1.4 percent in 2013 and 2.2 percent next year. Net absorption of retail space is projected at 11.0 million square feet in 2013 and 18.1 million next year.

Multifamily construction will meet demand

Multifamily Markets
The apartment rental market – multifamily housing – is likely to see vacancy rates edge up 0.1 percentage point from 3.9 percent in the fourth quarter to 4.0 percent in the fourth quarter of 2014, with new construction helping to meet higher demand. Average apartment rents are forecast to rise 4.0 percent this year and 4.3 percent in 2014. Multifamily net absorption is projected to total 239,400 units in 2013 and 211,300 next year.

Office rents should be going up

Vacancy rates in the office sector are expected to decline from a projected 15.6 percent in the fourth quarter to 15.4 percent in the fourth quarter of 2014. Office rents should increase 2.4 percent this year and 2.5 percent in 2014. Net absorption of office space in the U.S., which includes the leasing of new space coming on the market as well as space in existing properties, is seen at 32.2 million square feet this year and 46.1 million in 2014.

Industrial vacancies on the decline

Industrial vacancy rates are likely to fall from 9.2 percent in the fourth quarter of this year to 8.6 percent in the fourth quarter of 2014. Annual industrial rents are expected to rise 2.3 percent this year and 2.5 percent in 2014. Net absorption of industrial space nationally is anticipated at 97.0 million square feet in 2013 and 104.9 million next year.